Saturday, April 12, 2014

Five out of the last six trading days have seen the Dow Jones Industrial Average rise or fall by more than 100 points. This type of market volatility certainly can be unsettling to investors. In addition to these 100 point plus or minus swings, is the increased commentary by some well known market strategists that are calling for a significant downturn in the market. In spite of this volatility and the rhetoric on television news shows, the S&P 500 Index is down less than 4% from its high and only down 1.8% year to date.

The cause of the bearish market view is partly attributable to the correction occurring in some parts of the market. As the below chart shows, two sub-sectors of the market that have corrected significantly are the biotechnology companies (IBB) and the social media stocks (SOCL). A couple of the safehaven sectors, utilities and consumer staples, have held up well since the two momentum sectors below began to correct beginning in late February.

So, in reality, investors have found a reason to rotate out of the momentum sectors. From a positive perspective, this has brought the valuations of some of the momentum stocks back down to a more reasonable level.

This type of market environment provides the bears with a platform from which they can voice their bearish market point of view. Bullish investors need to pay attention and evaluate the points raised from the bears. Importantly though, the market's direction will trend in the direction of expected future earnings growth and the anticipated growth of the economy. From an earnings perspective, the first quarter of 2014 is shaping up to be a weak one. In a recent report from Factset, they note earnings are estimated to decline 1.6% in the first quarter. If this is realized, the Q1 2014 decline would be the first since earnings declined 1.0% in the third quarter of 2012 (2013 turned out to be a good one for S&P 500 stocks). The Factset report contains highlights from some companies that have implicated the harsh winter weather experienced in the first quarter as contributing meaningfully to weaker Q1 earnings. When companies miss earnings or lower guidance, they like to find a scapegoat that is something other than an internal operating issue--the weather is the scapegoat in Q1. However, we do believe the weather is a valid factor that has contributed to Q1 earnings weakness and may likely reverse itself in the last three quarters of 2014.

What is an investor to do in a market like being experienced at this point in time? One investor that is gaining a great deal of press recently is Marc Faber. Mr. Faber is predicting that the 2014 correction will be worse than the correction experienced in 1987. My problem with his correction call is the following:

I suppose if one always calls for a correction, they will eventually be right. And if Marc Faber is finally right that a 1987 style correction is in store for the market this year, should one sit out the market now.

Below is a chart of the S&P 500 Index going back to 1986. The chart clearly shows the 1987 correction when the S&P fell over 57 points to 282. About a year and a half later (April, 1989), if an investor stayed invested in the market, they would have recovered entirely from the decline.

In conclusion, corrections are difficult to predict. In fact, I do not know any famous market timers. One of many keys to surviving a correction is to have an appropriate allocation in one's investment account that can fund one's lifestyle without the need to sell stocks right after a significant correction. In that regard, I recommend investors read Howard Marks recent newsletter, Dare to Be Great. A few highlights from his report:

How do you think about risk? Is it volatility or the probability of permanent loss? Can it be predicted and quantified a priori? What’s the best way to manage it?

How reliably do you believe a disciplined process will produce the desired results? That is, how do you view the question of determinism versus randomness?

Most importantly for the purposes of this memo, how will you define success, and what risks will you take to achieve it? In short, in trying to be right, are you willing to bear the inescapable risk of being wrong?

The real question is whether you dare to do the things that are necessary in order to be great. Are you willing to be different, and are you willing to be wrong? In order to have a chance at great results, you have to be open to being both.

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